Friday, June 24, 2011

The country is facing massive unemployment and deficit problems, yet the Department of Health and Human Services is focused on stopping people from smoking. They have used their valuable time and scarce resources to choose nine color images of the horrible damage that smoking can cause. “This is a critical moment for the United States to move forward in this area,” pontificated Dr. Margaret A. Hamburg, FDA Commissioner, somehow keeping a straight face. The images “will help encourage smokers to quit,” expounded the highly educated Secretary of HHS, Kathleen Sebelius. The New York Times interviewed a few people on the street: One, Khariton Popilevsky, speaking for a number of smokers, said: “Telling me things we already know. I’ll still be smoking.”

Perhaps they should have saved all this time and money and listened to a young, commonsensical Arab immigrant Saiful Islam who works for a convenience store: “Higher prices would cut sales a lot more than images on a pack.” …And increase government revenues. But, then what would Ms. Sebelius do for a living?

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“Let Them Eat Cake”

According to Dow Jones, Washington lawmakers are considering changes in how the CPI is calculated…again. The Bureau of Labor Statistics (BLS) calculations used to determine the CPI have been changed at least six times since World War II, most recently in 1995. In each case, the changes resulted in – surprise! – lowering reported rates of inflation. Such actions resulted in lower Social Security payments, raising GDP estimates and making the claim that real wages have fallen over time unfounded. In 1995 Congress appointed a commission – the Boskin Commission (led by Professor Michael Boskin of Stanford) – to study CPI’s ability to estimate inflation. (I always thought CPI was supposed to reflect inflation?)Their findings resulted in changes that reduced annual inflation by between 0.8%-1.6%. The current proposal would adjust for changes in people’s assumed behavior. For example, if beef prices rise, consumers are more likely to eat chicken; when gasoline prices fall, people drive more.

Since the proposed changes would lower reported inflation numbers again, that would impact income tax brackets, and reduce federal programs that are tied to the CPI, like Social Security, saving the government about $22 billion a year according to estimates, demonstrating once more that in Washington it is perception not reality that matters. Reducing spending and raising taxes, while doing neither, is manna from Heaven for politicians from both parties. But the American people are being treated like French citizens in 1792. Term limits!!

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“There are those who work for a living and those who vote for a living”

Food stamps have been renamed the Supplemental Nutritional Assistance Program (SNAP.) That crisp acronym has attracted a lot more recipients who are receiving more money. A large increase in recipients is typical of recessions. However, eligibility for SNAP was expanded in March of 2009. Caps on assets were removed and minimum income was raised from 130% of the poverty level to 200%, and the 200% level was calculated after all deductions, no matter how many or for what. This has prompted a number of articles, some apocryphal I am sure, on how food stamps are being used to buy lobster, steak and champagne. But it has resulted in a 70% increase in recipients to 44 million (1 in 7 Americans) and a 133% increase in payments. (For comparison’s sake, in terms of recipients, in the 1970s only 1 in 50 received food stamps.) At this point thirty-five states have adopted the expanded program.

The issue of expanding recipients cannot be attributed to Mr. Obama and the Democrats alone. According to James Bovard, writing in yesterday’s Wall Street Journal, food stamp recipients under George Bush by 2007 rose by 50%, and that was prior to the recession. Nevertheless, an increase in recipients adds to those who sup on the teat of government. It tilts the political playing field in favor of big government, as H.L. Mencken so succinctly noted about Americans eighty years ago, in the quote above.

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“The Mile-High Club at Southwest”

Perhaps this story should be entitled “One Who Aspired to the Mile-High Club!” An unnamed pilot (discretion apparently is important in the airline industry) using an air-traffic control frequency (perhaps he was trolling?) complained about the “slim dating pickings” among the Chicago based flight attendants. He was overheard as saying that of a dozen attendants, eleven were “over-the-top *&%@* homosexuals and one a granny.” (My wife, a grandmother of ten, would take exception with the insultingly gratuitous term “granny”!) The airline reported that the pilot – still unnamed – was suspended and sent to “sensitivity training.” Sensitivity training being a short course in the airline industry, he is now back in the pilot’s seat. However, it appears that the man must be excessively sensitive, at least to his own desires. He would have been better served by being sent to technical school, a place that would have taught him the purpose of each toggle switch in the cockpit. On the other hand, if he had been my father’s son he would simply have been spanked.

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I will be away until July 7, accumulating ideas that can be incorporated into future Thoughts of the Day, but more importantly spending precious time with my wife, children and grandchildren. Enjoy the fourth!

Thursday, June 23, 2011

One cause of the current financial malaise that has infested our economy is that we have become victims of what Joseph Schumpeter called creative destruction. Professor Schumpeter referred to businesses and the way in which advances in technologies outdated existing modes; if managements did not adopt they died. Companies experience a cycle of life – from concept to birth, through adolescence, maturity, old age and death. Societies and countries are subject to similar influences.

To remain in the game, a country (or a company) must constantly reinvent itself. However, as a society becomes wealthier, the people become increasingly less willing to take risk, to adapt. We become caught in a web of comfort. The United States, historically, has had an advantage over other countries in its immigrant population. Most commentators comment on the importance of attracting the educated and the wealthy, and that should be a focus. But it is also critical to let in those that are poor, uneducated and hungry; for those are the ones who are motivated by the possibilities our country offers. They are willing to do the kind of jobs too many Americans find are beneath their dignity. Yet, those are the very jobs most of our ancestors were pleased to accept. When I read or hear of our nativist attitudes toward the millions of illegal immigrants who, at great personal risk, have crossed into our country from Mexico, I cringe. It is not that I favor breaking laws, I do not; but I do know that if we are not shaken from our lethargy we will wither and die.

As Bill Gross of PIMCO wrote recently in a fascinating piece, “School, Daze, School Daze”, we have ceded manufacturing “to China and other developing labor markets.” “Labor,” he writes, “is much more attractively priced over there than here.” A hundred years ago, textile mills moved from New England to the South, as northern labor priced themselves out of business. Many of those mills in New Hampshire, along the Merrimac and Contoocook Rivers, when I was growing up were empty, forlorn relics of a bygone age. For those who could not (or would not) adapt, poverty became a constant companion. In time, software engineers and internet entrepreneurs began to inhabit space previously occupied by women and men working long shifts on looms and spinning wheels; life adjusted.

There are those, like unions, who would have us turn inward; hence the delay in getting the President to push forward on free trade agreements with South Korea, Panama and Colombia. But, as the 1930s and Smoot-Hawley taught us, it is trade, not isolationism, that works.

As a country, we are either New Hampshire at the turn of the last century or IBM in 1991. We cannot afford to wait several decades, as New Hampshire did, for people to adapt. We must be more like IBM, when Louis Gerstner arrived as CEO in 1992 and shook the place up. Mr. Gross, in my opinion, is correct in that the long-term answer lies in our attitudes toward education and training. Other than providing young people four years in which to “grow up” and keeping them off the unemployment roles, most graduates emerge with a degree, but not much better educated than when they entered. Even worse, they have not learned the skills allowing them to compete in a global environment. In a society that glorifies wealth and personal possessions (see Tuesday’s New York Times article on the City’s new Core Club,) people look down on technical schools and apprenticeships, yet it is exactly those types of training programs that are needed.

Bill Gross’s short term answer: “Government must temporarily assume a bigger, not a smaller role in this economy.” Perhaps, but in past crises government was not in this deep a deficit hole. “There’s a longing,” as Michael Barone wrote in yesterday’s Wall Street Journal, “on the left for the golden years of the 1940s, ‘50s and early ‘60s.” Big government, big companies and big unions dominated the economy. Incomes were more evenly distributed, and people had confidence in the wisdom of government and business leaders. That “Midcentury Moment”, as Mr. Barone calls it, has remained embedded in the memories of many Democrats who hope we can return to those “golden” years. However, as Thomas Wolfe wrote: “You Can’t Go Home Again.” Not only can’t you, you don’t want to. As Mr. Barone explains, those years were characterized by a uniform conformity that produced the “organization” man. Segregation was rampant throughout the south. Women were denied the right to work in many organizations. It was only the ending of the “Moment” that ushered in the civil rights movement and equal rights for women, along with declining union memberships and rising entrepreneurships.

Public jobs focused on infrastructure and other projects may be a short term answer. But it is not the answer. Certainly our roads and bridges are in terrible shape; so putting out-of-work people fixing in-need-of-repair roads and bridges would provide needed jobs. But a focus on Green energy, for example, should become simply a focus on energy.

The problem we face is unlike anything we have known, and the shift we must make is cultural, not just economic. Our competition is global. Workers in places like China are qualified and are willing to work for less. The very size of our federal debt prevents government from providing the type of solutions enacted, for example, in the 1930s. We cannot even agree to discuss entitlements that we cannot afford. The complexity of our tax system means that it benefits only the very wealthy and the country’s largest corporations. (It is ironic but not surprising that President Obama’s closest business advisor, Jeffrey Immelt, is the CEO of a company that paid no corporate taxes last year and whose workforce has not expanded in twenty years.) American companies have $2 trillion parked overseas, yet our tax system prevents its repatriation. And excessive regulation acts as a drag on the economy.

Our schools are inadequate for the world in which we live. Mr. Gross wrote of colleges, but the problem begins in our elementary schools, which are overloaded with staff and not teachers, schools which are run for the benefit and well-being of those who work there, not for the students who are there to learn. The concept of universal moral standards (ala James Q. Wilson) has been relegated to some dusty closet. We deify the wealthy on TV and in the Press. We have inculcated the people with a sense of something for nothing. Lawsuits have become commonplace. Lotteries have become ubiquitous and encouraged by politicians of both parties, yet the tax they extract is regressive and we hear no complaints.

The story of our economic success has been the story of individual initiative, creativity and entrepreneurship. It would have been impossible for most of us four decades ago to foretell the type of economy we live in today. In the same vein, the future is not foreseeable. President Obama’s observation that technology causes job losses is wrong. Creative destruction permits the birth of new industries and jobs. Just because we cannot know what those jobs will be, does not mean they will not exist. Out of chaos comes opportunity. It just has to be encouraged.

Wednesday, June 22, 2011

June 22, 2011
Good ideas are sometimes corrupted by greed. Unions, in my opinion are examples of ones that have been, a subject I have often written about. Class action suits are another. Advantages to class action suits include the increased efficiencies and lower costs that aggregation allows, and the fact that small monetary recoveries do not provide proper incentives to lawyers. Class action suits can also be a means of purposefully changing, in a good way, the behavior of a group of people; i.e. schools which had been discriminating on the basis of race, or doctors who may not have been reporting instances of child abuse. Additionally a class action ensures that all plaintiffs, regardless of who they are and when they filed, be treated equitably.

English and American laws have long embedded the concept of class action suits. The term “group litigation” was common in medieval England. In the United States, the earliest predecessor to class action was Equity Rule 48, which allowed for representative suits in situations where there were too many individual parties. In 1966, a major revision to the Federal Rules of Civil Procedure (FRCP) made the opt-out class action the standard option and gave birth to modern class action.

But class action suits have their share of imperfections. Tort lawyers, in particular, have taken advantage of the enormous sums certain settlements bring, and then have used that financial clout to keep “friendly” politicians (usually Democrats) in office. There are courts (known as “judicial hellholes”) that regularly side with plaintiffs, preventing defendants from being able to adequately defend themselves. Secondly, legal fees often consume too large a percentage of the settlement. In fact, one might argue, in too many cases the fees have become the casus belli for the suit. The American Enterprise Institute notes a case involving an Alabama state court in a class action suit against the Bank of Boston. Court-approved attorney fees exceeded the minimal recovery available for the plaintiffs!

Too many salivating trial lawyers have come to view class action suits as a feeding trough. Tobacco cases were notable in generating hundreds of millions of dollars to a handful of lawyers, while providing very little to the plaintiffs.

Two Supreme Court decisions were handed down Monday in respect to a ten-year old case involving Wal-Mart. Six women sued Wal-Mart alleging discriminations in terms of salaries and promotions. Their lawyers chose to turn the suit into a class action. In a 9-0 decision, the Court ruled that the 9th District Court had improperly certified the class action suit in its current form. In a separate vote, the Court voted 5-4 along ideological lines, saying there were too many women (1,500,000) in too many jobs at Wal-Mart to conform to a single lawsuit. The company employs 2.1 million people in 8000 stores in fifteen countries. The Company contended and the Court agreed, that trying to defend the treatment of 1.5 million women employees, regardless of the jobs they held or where they work is unfair. Defendants, even when they are businesses, have rights as well as plaintiffs.

The importance of the decision should not be dismissed. Class action suits have become increasingly frivolous and cost businesses billions of dollars. The 9-0 decision regarding certification sends a message that courts cannot bend rules and undercut constitutional rights in order to make a class certification fit. Not surprisingly, the New York Times rued the decision, writing that “the court has made fact-finding a major part of certification, increasing the cost and stakes of starting a class action.” I, for one, never realized that facts were not important in legal matters!

The country is in financial straits. Over the past ten years, ten million people have been added to the employment roles, yet only 1.8 million jobs have been added. Jobs come from the private sector; to the extent that government, unions and regulators hamstring the ability of business to expand and grow, the effect is negative for economic growth. We all suffer.

This is not to excuse Wal-Mart. The company is no paragon of virtue. While Hillary Clinton served as a member of their board of directors from 1986 to 1992 when her husband was elected President, there are still only three women directors today out of a board of fifteen. And, worse, only one of twelve senior officers listed in their 2010 annual report is a woman. Women have made far more strides in Congress than at Wal-Mart. In 1980, eighteen women served in Congress; today there are ninety-two. Regardless, I defend their right to survive.

In an op-ed in today’s New York Times, Nelson Lichtenstein, a professor of history at the University of California, Santa Barbara, bemoans the Court’s decision suggesting that it “leaves millions of service-sector workers with few avenues to escape the grinding work life and limited opportunities so many face.” That may or may not be true. But what is true is that we live in a world in which competition is global and that to survive our companies must consider the needs of all their constituents – employees, the community, their customers and the shareholders who own the business. Wal-Mart appears a perfect fat-cat target for tort lawyers looking to add to their bank balances. The company generates over $400 billion in revenues from more than 8000 stores in fifteen countries. It employs 2.1 million people, most of them in this country. Yet, demonstrating that shareholders have suffered, the price of its stock is at the same level it was twelve years ago. Tort lawyers have no interest in the survivability of a firm like Wal-Mart. Their interest is only in what they can extract from the business today.

It is not the workers who are the losers, as the Times would have one believe, it is the trial lawyers. Nothing in this life is forever. We are not an island. We are part of a world that has been shrinking in terms of its global competitiveness. To survive, a company like Wal-Mart must remain competitive. As long as they stay in business they will continue to offer opportunities for those who want to work. Killing the goose is not the answer.

Monday, June 20, 2011

We live during a time when economic growth will be mediocre at best for several years. That is due to the basic tenet that in a deleveraging world growth is compromised. Credits and debits, as Albert Wojnilower recently wrote, are opposite sides of the same coin. One depends upon the other. As debt shrinks, or at best expands only modestly, so will credit; economic growth relies on expanding credit. The fact that the U.S. has an expanding population serves as our savior in times like these.

It is possible that a focus on exports to the developing world will offset moderating domestic consumer demand, but, in an economy in which the consumer comprises about almost 70% of the economy, that puts a lot of pressure on exports. At best, they could prevent the country from slipping into another recession. Our domestic economy will have the additional drag of a likely default (in some form) by Greece on their sovereign debt. As to whether a defaulting Greece portends a second coming of a bankrupted Lehman, nobody knows. My guess is that it would not. Greece seems to me to be the most drawn out, slowest motion default in history.

Over time, the stock market mirrors the economy, but does not always march in lock step. While reported economic numbers are a matter of hard data, the stock market rises and falls on perceptions on the future, and is greatly influenced by human behavior – we feel good about things, or we don’t. For the past several weeks the market has reflected multiple concerns: Europe is a mess; a two year advance in the S&P 500 of 88% was deemed to have been too aggressive, or unwarranted; a polarized political situation has raised concerns about the debt ceiling; earnings reports, in some instances, have been less than robust; inflation, as measured by both core and headline numbers, has increased to the highest levels in a decade; a growing sense of malaise has permeated America’s middle class; riots in the Middle East and North Africa and what appears to be an intensifying hot war in Libya risk shortages of crude oil, and a slowdown in China’s economy have provoked a number of demonstrations and risk contaminating global expansion.

One of my favorite collectors of market data and market gurus is Laszlo Birinyi who operates the eponymous firm, Birinyi Associates. I have known Laszlo for over thirty years. One of his sayings is that when problems are as prominent as the nose on one’s face (what he calls the Cyrano Principle) they tend to be priced into the market. Most of the concerns mentioned above – if not all of them – are well known and are not original. Of course things could get worse. Congress may decide that an increase in the debt ceiling is not warranted. A Greek default could lead to others, ala a Bear Stearns to Lehman to Merrill. Inflation could ramp up sharply and the economy stall, leading to a 1970s style stagflation, (or what Doug Kass of Seabreeze Partners has called “screwflation.”) The malaise among the middle class could intensify and spread. Corporate earnings could be squeezed between rising raw material prices and declining final demand. Oil supplies in the Middle East could be shut down by rising tensions. And who knows what demons may lurk in China?

But behind those dark and somber clouds lie a few rays of sunshine. Consumers have been reducing debt and increasing savings, though both numbers lag where they were fifteen years ago. Commodity prices have recently declined. Banks, either voluntarily or under duress, are increasing capital ratios. Reality is being faced. Politicians of both stripes (Andrew Cuomo in New York and Chris Christie in New Jersey, for example) are recognizing the necessity of dealing with unfunded pension and healthcare liabilities. Even AARP, according to a Friday article in the Wall Street Journal, has dropped its long standing opposition to cutting Social Security benefits. The market’s reaction to LinkedIn’s IPO has been cited by some as a return of the 1990s, but also suggests that speculative money is looking for a home. Both the Wall Street Journal (“Death of the Duopoly”) and the New York Times (“Standstill Nation”) did weekend stories on Washington’s stalemate just as President Obama and Speaker of the House John Boehner were sharing a golf cart as they played the game on Saturday. And many large and well known stocks sell at less than ten times earnings. In fact, Bloomberg has a story this morning suggesting that stocks, on anticipated earnings, are selling at the cheapest levels in twenty-six years.

Three weeks ago (June 1) I wrote a piece, “Are Large Stocks Attractive?” I concluded they were and was promptly proved wrong, or, at a minimum, proved too early. They are cheaper today.

Measuring investor psychology is an art, not a science. I certainly do not profess to any expertise in the field. But I do know that following the herd is not the way to go. In my opinion, we are nowhere near the point where we could expect a multiyear bull market similar to the 1980s and 1990s. Those were truly “black swan” years. But so were the events that led to the collapse of Lehman in 2008; barring unpredictable consequences of a defaulting Greece that’s not where we are either.

As David McCullough said in an interview with Brian Bolduc in Saturday’s Journal, “There is no such thing as a foreseeable future.” However, knowledge of history permits a perspective that can help remove emotion from market decisions, and provides the assuredness to purchase good companies at reasonable prices, even recognizing that prices, short term, may become even more reasonable.

The long term is nothing more than the stringing together of short periods of time. There is nothing new or unique in believing that we live in momentous times. The last hundred years witnessed extraordinary events – World War I; a global “Great Depression;” World War II; the Cold War and its end; placing a man on the moon, and 9/11. Yet through it all, the Dow Jones Industrial Averages compounded at 5.3%. Dividends provided an additional two to three hundred basis points. Total returns for stocks far outdistanced inflation which, during the past 110 years compounded at about 3%.

Following the market collapse in 1929, it took twenty-five years for the market to recover to where it had been on the eve of the greatest stock market crash the world has ever seen. Yet compounded price returns for the DJIA have risen 4.3% since that date in late August 1929, again besting inflation which eroded the dollar annually by about 3.1%. Dividends added about 200 basis points to bring compounded total returns to about 6.5%.

Where have all the investors gone? Unlike the flowers in Pete Seeger’s song which went to cover the graves of dead soldiers, the disappearance of investors will likely prove more ephemeral. At least, I hope so.

Thursday, June 16, 2011

Someone arguing, syllogistically, that good health and wealth are related would find themselves baffled. On a GDP per capita basis, the U.S. ranks fourth among nations. In terms of health spending as a share of GDP, the U.S. is number one. Yet the United States is fiftieth when it comes to life expectancy.

A report out this week from the University of Washington’s Institute for Health Metrics and Evaluation suggests that while life expectancy in the United States continues its upward trend, there are widening dichotomies between the rich and the poor. For example in Fairfax County, Virginia men had the longest life expectancy in the country – a little over 81 years, equivalent to life expectancies in Canada or Australia. Yet, one hundred and fifteen miles south, in Petersburg, Virginia, life expectancy, at 66.9 years, is one of the lowest in the U.S. for a male, and is equivalent to life expectancy in Guyana or India. Healthcare would not seem to be evenly distributed.

However, a report in the New England Journal of Medicine that was summarized on Bloomberg this morning has a “dog-bites-man” piece affirming that children on private insurance are able to get doctor’s appointments more quickly than those on Medicaid. Money talks, and unfortunately life is never completely fair. The real news would have been if children on Medicaid had found it easier to secure medical treatment than those on private insurance. That report will likely be used by liberals to argue that government (Medicaid) is not doing enough. It should, though, add fuel to the concept that healthcare reform should involve increased competition among insurance companies – the most obvious step would be the permitting and encouragement of cross state border competition.

The social welfare states of Europe, seemingly the model that the Obama administration would prefer to follow, spend less on healthcare than does the United States, yet have longer life expectancies. However, the costs of those programs have been a notable decline in GDP per capita. In 1991, six of the top ten countries ranked by per capita GDP, according to the World Bank, were European. Today, only two European countries make that list – Switzerland, which has gone from two to seven, and Norway that remained at four. In contrast, the U.S. moved up from seven to six. In 1991, Japan was on the list and France was number eleven. Today, Japan is number twenty-two and France is number twenty. The problem with socialism is that economies die a slow death, as incentives to produce are lessened and as capital for investment seeks better returns in other places.

Empirical observation suggests that our relatively low life expectancies are not so much a function of healthcare, or its availability, but are a consequence of bad eating habits and lack of exercise. Both of those factors, in my opinion, reflect poorly on our educational system. An additional cause, again in my opinion, is that the Bureau of Labor Statistics, in changing the factors that measure inflation, has done a disservice to policy makers. While Congress and the Federal Reserve take comfort in low core inflation, rising food costs have sent poorer consumers to fast food outlets.

The relevance of all of this can be seen (and heard) in the rancor in Washington – should the focus be on economic growth, or should government be concerned with healthcare and lifestyles? Or can we do both? Depending on which side prevails will largely determine the type of society in which we will live. The differences between the two political Parties in large part reflects the fact that there is so much at stake; thus the difficulty in coming to a consensus on the budget negotiations. Republicans have resorted to using the deficit card, while Democrats have avoided any sort of a budget proposal. Nevertheless, it is my sense that some sort of reconciliation, in the debt/deficit ceiling talks, is close. Vice President Biden has promised some legislation that can be sent to Congress before the July 4th recess. Any reconciliation may prove ephemeral, but such an event should raise confidence, at least temporarily.

The answer to the question above is that we can do both. We can decrease regulation and simplify the tax code to improve business development. (In spite if President Obama’s comments yesterday about ATMs and airport kiosks adding to unemployment, technology and productivity improvements are a natural factor in a dynamic and expanding economy.) Healthcare would benefit in allowing insurance companies to compete across state borders, in encouraging the growth of in-hospital clinics that can absorb some of the costs of emergency rooms, in reforming Tort laws, in focusing insurance on catastrophic events, and in encouraging the patient to be more involved in choosing doctors and procedures.

A friend of mine used to say, “My mother never said it would be easy.” Life never is, but problems are always most momentous when we are in their midst. In retrospect, most mountains seem like hills. It is a lesson that history teaches.

Wednesday, June 15, 2011

Even though the election is almost seventeen months away, it seems obvious that the key to electoral victory will be jobs. President Obama wants to keep his. Seven republicans were in Goffstown, New Hampshire Monday night at St. Anselm’s College vying for a chance to take Mr. Obama’s job. According to the Bureau of Labor Statistics, there are 24.6 million Americans either unemployed or underemployed. On the other hand, there are more than a million jobs, primarily in healthcare and technology, for which qualified people have not been found.

Unemployment in May was 9.1%. Other than Franklin Roosevelt, no American President has been reelected with unemployment above 8%. However, the absolute level of unemployment will not be the key, it will be the trend. And, regardless of our political preferences, we hope, for all our sakes, the trend will be toward improving job growth.

But, keep in mind, the lack of job growth is a symptom, not the disease. The disease results from policies that have damaged economic growth. A manifest of the problems facing the country is long and has become embedded in our culture over several decades. Sole blame lies neither with the current administration, nor with the former; though both share in responsibility. It is one for which we all share blame. The following is a partial list of some of the problems, in no particular order. Some will disagree with the ones I’ve named, while others will note ones I have omitted.

* Debt – As a nation we have too much. Corporations and consumers have begun to reduce theirs’, but federal and state debt has expanded and is unsustainable. Our $14 trillion in debt is scheduled to rise to $25 trillion by the end of the decade. Short-dated maturities and artificially low interest rates have masked the costs of our debt. By 2020, normalized interest rates would cost $800 million, more than 20% of today’s federal budget.

* Education – Our public schools are failing too many students, especially in inner cities. Unions have been adamant in support of teacher’s rights, at the expense of our children. Their political contributions place them among Democrat’s largest donors.

* Entitlements – The people, thanks to Congress, have come to expect government care and support that is no longer affordable. Contrary to protestations, Obamacare will only intensify the problem. It is the reason so many unions, states and businesses have been granted waivers.

* Taxes – The problem is not rates, but its complexity. It favors the very wealthy at the expense of the middle class, and large corporations (i.e. GE) at the expense of small and mid-sized businesses.

* Income disparities – While disparities have narrowed somewhat since the heyday of option grants in the 1990s, they remain unhealthily wide.

* Infrastructure – Our bridges, roads etc. are not only a national disgrace, they impede our economy and discourage foreign investment. Photographs comparing Hiroshima to Detroit is a visible manifestation as to how little we have done and how far we must go.

* Global competition – Excessive regulation and an immigration policy that is an insult to a nation of immigrants have hindered our ability to compete globally. Opposition from a handful of union leaders has prevented the President from signing free trade agreements with South Korea, Colombia and Panama.

Some of these problems are being addressed, most notably the effort of charter schools and programs such as Teach for America. But progress is slow, with the teacher’s unions fighting reform every inch of the way. President Obama said he wanted an “adult conversation;” he then slammed Congressman Paul Ryan for proposing changes to Medicare, while offering none of his own. As Clifford Asness of AQR Capital Management wrote in an op-ed in yesterday’s Wall Street Journal, the problem with the Administration is not the “uncertainties,” it is the policies put forward. But Republicans, other than Mr. Ryan, have not offered any real alternatives either. A pox on both their houses, say I.

David Brooks had an op-ed with which I agree. In yesterday’s New York Times, he wrote, “Pundit Under Protest,” in which he called for a “Hamiltonian agenda” that would be multifaceted and reinvigorating, combining the best of pro-market policies, while not ignoring the need for government.

Brazenly (and with no hint of a mea culpa,) the co-author of low interest rates, Fed Chairman Ben Bernanke said yesterday that “first we should do no harm.” Then added: “The status quo is not an option.” But he said nothing to relieve the financial squeeze people feel, or anything that would alleviate the belief of a lot of people that the decline we are in is not cyclical – that it has become secular.

I found myself thinking of Coleridge’s poem, “The Rime of the Ancient Mariner,” only with different words:

“No jobs, no jobs, not anywhere;

All Congress did was shout.

No jobs, no jobs, not anywhere;

So kick the bastards out.”

If only it were that easy. The situation in which we find ourselves is due in part to a political system that has evolved into a Congress that feels entitled to a permanent seat in Washington. Most Congressional districts are considered “safe”. Men and women who sit in Congress no longer represent the people who elected them; instead, they work for the special interest groups that fund them. Term limits remains the best answer. Jobs are needed.

Tuesday, June 14, 2011

“Humans do have a rudimentary moral sense from the very start of life.” So wrote Paul Bloom, Professor of Psychology and Cognitive Science at Yale University in the New York Times. In “The Moral Life of Babies,” the article published May 5, 2010, he concluded however: “The aspect of morality that we truly marvel at – its generality and universality – is the product of culture, not of biology.” Because of civilization, defined by Webster as “an advanced state of human society, in which a high level of culture, society and government has been reached,” the story of man should reflect an improving moral sense. Unfortunately, history proves otherwise.

A list of the ten most evil people of all time includes six who lived in the Twentieth Century – Adolph Hitler, Adolph Eichmann, Pol Pot, Mao-Tse Tung, Idi Amin and Joseph Stalin. While it may be unfair to compare those who killed millions with computer hackers, the ability to distinguish right from wrong remains a lesson unlearned by too many.

The proliferation of smart phones, along with the advent of Facebook and Twitter, has not only increased the vulnerability of millions of people to cyber attack, they have a potentially negative impact on social intercourse. M. J. Zuckerman, in a USA Today article “What Fuels the mind of a Hacker,” suggests that some suffer from Asperger Syndrome, antisocial people who are good with numbers. Innuendos visible in a face to face meeting are invisible in an e-mail or instant message. Would a seventeen-year old girl be as susceptible to the advances of a forty-six year old Congressman if not distanced by cyberspace? Does the relative anonymity of the internet make the act of displaying one’s genitals socially acceptable? Congressman Anthony Weiner’s first public reaction was that his Twitter account had been hacked – a red herring that, unfortunately for him but fortunately for the rest of us, failed almost immediately.

Given the rise in cybercrime, Mr. Weiner’s initial explanation was, for a moment, credible. A million Sony PlayStation accounts were compromised a little over a month ago. Citigroup reported that 210,000 accounts were recently hacked. Bank of America had a similar experience, as did Google’s G-Mail and Apple iTunes. Last evening, hackers claimed to have compromised Senate security and this morning they claim they will take on the Federal Reserve. Reuters, on June 3rd reported that concerns over security issues could slow the growth of cloud computing, a market that globally “could reach $55 billion in 2014.” If morality is more a function of culture than of biology, as Professor Bloom attests, our society is becoming less civilized.

Whether we approve or not, whether we use the internet or not (and who does not?) all our personal information – bank accounts, Social Security numbers, medical records – are floating somewhere in cyberspace. Like Willy Sutton who robbed banks because that’s where the money was, these thieves hack files because that’s where the data is. A web solutions company, Crucial Paradigm recently issued a report, “Hacking Attacks – How and Why.” They list five forms of attack and offer a number of explanations as to why hackers do what they do. The most common form of attack, a virus, vindictively replicates itself in milliseconds rendering useless computers, programs and software. Among the most insidious are “worms”, quietly consuming resources until the system becomes overloaded and ceases to function. Worms combine, according to the report, elements of Distributed Denial of Services (DDoS) and viruses.

Crucial Paradigm suggests that the reasons hackers attack include everything from revenge, to corporate theft, to stealing identities and information, to spying on friends, to the intellectual challenge. Anyone connected to the internet, which today includes most everybody, is vulnerable to being hacked.

Two articles yesterday lent relevance and immediacy to these concerns. The Wall Street Journal reported that Citigroup waited as long as three weeks to notify credit card customers of a hacking attack. That seems an irresponsibly long time, when milliseconds are all that is needed to access credit and identity information. Citigroup did say that the breach did not compromise card security numbers or Social Security information. Nevertheless, it makes an already skeptical cardholder even more nervous. The UK Business News wrote that “an unnamed security expert” has indicated that the recently revealed cyber attack on the International Monetary Fund (IMF) could have been state sponsored. “The hack,” according to yesterday’s article, “was designed to install malicious software that would create a ‘digital insider presence,’ allowing the hackers access to all the fund’s sensitive financial data.” The consequences, as one can well imagine in this day of instant money transfers, could be dire, and recall Lex Luthor in Superman 3, when he plotted to exact a penny from every money transfer as a means of making billions.

Hackers, though, can work for the “good guys.” In January, the New York Times reported that Israel, with U.S. help, inserted a computer worm, “Stuxnet” into the Iranian nuclear operation, thereby delaying their nuclear program. The worm was developed at Dimona, the Israeli nuclear arms development center in the Negev desert.

Insuring the security of the internet has proven almost impossible. A group called Anonymous, run by Jesse Willms, operates under the motto: “We are legion. We do not forgive. We do not forget.” They see themselves as Internet vigilantes, “fighting for truth and democracy.” According to a posting from Mr. Willms, the U.S. government attempted to learn more about his company, so hired a security firm to investigate. Aaron Barr, CEO of HPGary, was asked to infiltrate the group. Before Mr. Barr had a chance to do his job, Anonymous had put 50,000 of his confidential e-mails on the internet, hacked his twitter account, posted his Social Security number and wiped out his laptop and iPad. Mr. Willms wrote: “I think it is safe to say Barr won’t be selling anything to the FBI – or messing around with Anonymous again.”

So what can be done? One answer is to accept the world as it is and live with the heightened security demands. Over the weekend Randall Stross had a fascinating column about passwords and encryption, “Digital Domain,” in Saturday’s New York Times. In the article he quotes Steve Gibson, a security expert and chief executive of Gibson Research Corporation who claims that the single most important factor in a password is its length. Mr. Stross writes: “Mr. Gibson’s page says that it would take a hacker 2.43 months to go through every nine-character combination offline, at the rate of a hundred billion guesses a second,” but a ten-character password, “at the same rate would take 19.24 years.” A better answer, but reflecting idealism over reality, is to reassert what Professor James Q. Wilson has called “our moral bearings.” He says there is in all humans “a desire not only for praise but for praiseworthiness, for fair deals as for good deals, for honor as well as for advantage.” If only that were so. None of Professor Wilson’s words are likely to stop hackers, but they are worth pondering.

Monday, June 13, 2011

Last Thursday, the New York Times described the just-concluded OPEC meeting: “It was the first time in two decades that OPEC delegates could not arrive at a public agreement at a formal meeting.” “Acrimonious” was the Wall Street Journal’s way of putting it. The Journal quoted one delegate from the Gulf region who said that the failure to reach a consensus “represented a breakdown of the group’s fundamental principle.”

While the stated differences between the two camps (Iran, Algeria, Angola, Venezuela, Ecuador and Libya on one side with Saudi Arabia, UAE, Kuwait and Qatar on the other – and Nigeria and Iraq not taking sides,) reflect their respective views on the global economy, the tension reflects a manifestation of the enmity between the Saudis and the Iranians, flavored with pro-democracy movements in the Middle East and North Africa. (The lack of agreement is also indicative of the fact that some countries can increase production, while others are at or near their limits.)

It is Iran’s pursuit of nuclear weapons that is most disquieting and which lurks behind these sessions. Israel has been the country most vocal in calling a halt to Iran’s continuing progress toward developing nuclear weapons, but Saudi Arabia must be as fearful. The country is immensely rich, with an estimated 264 billion barrels in proven reserves. They are currently producing a little less than 10 million barrels per day – approximately 140 barrels per year for every citizen. The ruling classes have an enormous stake in perpetuating a stable Middle East and continued global economic growth. In contrast, Iran, with a population of 78 million and despite being OPEC’s second largest oil producer, ranks 88th on the CIA’s list of nations when listed according to per capita GDP. (OPEC members Qatar and Kuwait rank 2nd and 8th, respectively.) Iran stands to garner far more prestige and clout within the region as a nuclear power; certainly that is the belief of the terrorist who serves as President of the Islamic Republic of Iran, Mahmoud Ahmadinejad.

Without the backing of China and Russia for more intense sanctions, and with a U.S. President reluctant to take a strong, unilateral stand, Iran’s eventual membership in the club of nations with nuclear weapons seems assured, perhaps coming as early as the end of this year. Israel may once again come to the world’s rescue, but she could only do so with U.S. support, an unlikely prospect under the Obama administration. It is conceivable that hackers who regularly break through bank security programs could be employed to wreck the computers and software that govern Iran’s nuclear pursuit. Keep in mind, a nuclear-empowered Iran would have severe repercussions on the entire Middle East. An arms race within the region would likely follow. The ability and willingness of Saudi Arabia, and her OPEC allies (Kuwait, Qatar and the UAE) to serve as allies of the West would be at risk.

The “Arab Spring” that infected the region was deferred in both Iran and Saudi Arabia. In Iran, two years ago the Green Revolution was brutally put down, while the United States, ignobly, remained silent. A photograph of a shot and dying 26-year old Neda Agha-Soltan made its way around the world on YouTube and may have been a catalyst for the pro-democracy movements this year in much of the Arab world. Saudi Arabia used another old fashioned remedy – bribery. Friday’s New York Times reported that King Abdullah paid an extra two months’ salary to all government employees and paid $70 billion for 500,000 units of low-income housing. Thus far Riyadh’s efforts appear to have worked, as the only major street protest (March 11) largely fizzled.

The developed (and developing) world will gradually utilize more renewable energy sources, but the process is slow and expensive. No matter what the pundits may say, progress will be measured in generations, not years. Wind farms and solar panels, as attractive as they are in theory, will not do the job. In the meantime fossil fuel consumption will continue to rise, especially as developing nations increase their living standards. The CIA estimates that provable reserves in the U.S. amount to 19.12 billion barrels. However, the potential is far higher. If one adds in the estimated reserves from the Arctic National Wildlife Refuge, the Alaskan National Petroleum Reserve and the Bakken Reserve, then estimates rise to 134 billion barrels.

In not choosing to develop our own sources, we only become more reliant on the Middle East. Iran with nuclear weapons alters the balance of power in the region in a very negative manner. OPEC currently produces 40.1% of world production, but more important, according to the World Fact Book, they hold 62.1% of the world’s reserves. Our self interest requires a stable Middle East. Democratic governments are the best guarantors of peace. The “Arab Spring” we have been witnessing is an indication that the lure of freedom appeals to all people and that democracy is its best manifestation. But the protestors need our support, both moral and real. For all the whining about the Iraq War, that country, unlike any others in the Middle East apart from Israel, is now a fledgling democracy. A nuclear-empowered Iran would have an enormously destabilizing and negative effect, yet the United Nations and the developed world, including Washington, appear to have a surprisingly complacent attitude as to such an eventuality.

The unstated implications of the OPEC meeting that concluded last week with no resolution may portend a future far more frightening than simply a matter of quotas.

Thursday, June 9, 2011

Acapulco, on Mexico’s west coast, is considered one of North America’s most beautiful resort towns, attracting the “rich and famous” from all over the world. It is a city of just over 600,000 people noted for the daring young people who dive into its bay from its magnificent cliffs, yet during a single week in March more than thirty people were killed in Acapulco.

In an article in yesterday’s Wall Street Journal, readers were warned that, with drug related crime continuing to rise, tourists are “turning their backs on Mexico.” This is significant, as 22.4 million visitors spent $12 billion in 2010. However, drug trafficking is estimated to be a $50 billion business for Mexico. The costs to Mexico are incalculable. Residents of very poor towns like Badiraguato, which is considered the birthplace and heart of the drug trade, depend on the cartels for employment, so live under a code of silence. Costs for Mexican businesses that need additional security have increased by five to ten percent, according to some estimates that to me seem low. During the four years ending 2010 about 35,000 deaths have been attributed to the drug war, including a number of children. Mexico has almost 200,000 soldiers, including federal police, assigned to eliminating the cartels. So the question becomes, can Mexico eliminate its drug trade without inflicting too much damage on its own economy.

The effect on the United States is multifold, the most important of which include trade and immigration. It also includes arms. An operation run by the Bureau of Alcohol, Tobacco and Firearms (ATF) called “Fast and Furious” was designed to stop U.S. weapons from ending up in the hands of drug cartels. The concept was based on the idea that the cartels employ a series of “straw” buyers, individuals who buy in small quantities. Fast and Furious would then follow those buyers to their target, high-level traffickers. Somehow they lost them. (The Wall Street Journal has a front page article this morning on the subject.) Attorney General Eric Holder (who has responsibility for the ATF) has told Congress: “Under no circumstances should guns be allowed to be distributed in an uncontrolled manner.” Nevertheless, that is what appears to have been happening. Fast and Furious is proving to be neither fast nor furious.

The pressures facing President Felipe Calderón are enormous. Upon assuming the presidency in 2006, he declared that ridding Mexico of drug cartels would be his priority. Previous administrations had left them alone. Ignoring the problem was no longer a viable alternative.

When criminals run rampant, as they have in emerging countries – Russia and Colombia come to mind – and as they did during Prohibition in the U.S., they have a profound negative effect on the economy. In the U.S., the repeal of the Volstead Act in 1933 negated the need for bootlegging. In Colombia in 2002, newly elected President Álvaro Uribe vowed to rid his country of their drug cartels that had been operating for over forty years. Between 2003 and 2008, homicides related to drug trafficking were down 30%, kidnappings declined 80% and terrorist attacks went from 1,257 in 2003 to 347 in 2008. Progress continues; so today Colombia is considered a model for Latin America.

A peaceful and prosperous Mexico is important to the U.S. As a neighbor, they have been our second most important source of imported oil this year. They are our third largest export market. And, as we all know, they are the primary source of our illegal immigration.

Ridding the country of its drug cartels is not easy. Indicative of the difficulty has been the rise in the number of killings, from 2,837 in 2007 to 15,273 in 2010. U.S. Ambassador to Mexico Carlos Pascual has argued that the rise in violence may be a direct result of President Calderón’s military measures. To me, that sounds like a statement of the obvious. Desperate people, especially desperados, resort to desperate measures. (Through May of this year, while still very high, killings attributed to the drug cartels have declined on a pro rata basis to 4,741.) Regardless, to give in to the cartels is to doom the country to poverty and make far worse the relationship with the U.S.

There have been additional setbacks. In February, one U.S. Immigration and Custom Enforcement (ICE) agent was killed while supporting Mexican agents in their crackdown on the cartels. In early May, several hundred demonstrators took to the streets in the city Oaxaca, to voice their opposition to what they referred to as President Calderón’s “war against organized crime.” That march coincided with a National March for Peace for Justice and Dignity. Their argument is that the armed forces are receiving massive amounts of money while millions lack jobs and access to basic services. They also claim that Señor Calderón is subservient to the United States.

But these demonstrations are often initiated by the cartels. President Calderón is on the right strike. The question is can he stay the course. Eradicating the cartels is dangerous: it takes courage; it takes money and it takes time. The brutality of drug leaders knows no bounds, as the killings in Acapulco show. Children have been killed because of actions of their parents. Necessary spending on the military has diverted funds from investments in social programs and in state owned companies like PEMEX, which has lost 25% of its reserves since 2004. The company badly needs investment. Five years have passed since President Calderón made his vow. The cartels are powerful and enormously rich. People living in the remote regions of Northwest Mexico know no life other than one of fear and poverty. Success in this endeavor will benefit all the people of Mexico. Additionally, its success will accrue to the U.S. in terms of immigration relief and in terms of trade.

Wednesday, June 8, 2011

Mark Twain would have loved it. Not to see the Honorable Anthony Weiner in tears at what amounted to a confessional, but to know that little has changed in the stately, hallowed halls of Congress over the past one hundred years. Mr. Twain once remarked, “I don’t mind what Congress does. As long as they don’t do it in the streets and frighten the horses.” Presumably, had he been alive today, he might have added: “I don’t mind what they do on Twitter, as long as they don’t excite co-eds.”

Congress has long been home to thieves and perverts. It’s not just Congress; scandal has visited state houses and even the White House. (Wherever politicians gather, corruption is sure to follow.) And, amazingly, voters are famously tolerant of their wayward representatives, generally returning them to the scenes of their escapades. Mr. Weiner, thus far, has assured his constituents of his intent to keep his seat. In words Mr. Twain would have admired, Congressman Weiner said he had lied; he was dumb; he had exercised bad judgment; therefore he is obviously qualified to remain in the august halls of Congress.

What makes the Honorable Mr. Weiner seem such a jackass – the term he used a few days ago to describe CNN producer, Tom Barrett – is that his antics mimicked those of his disgraced former colleague, Republican Chris Lee. The dishonorable Mr. Lee had signed onto gawker.com earlier this year and sent a photo of his shirtless torso to a young lady, astonishingly describing himself as “classy.” Stupid, not classy, I would have thought. Once caught, he did have the good sense to resign almost immediately. Perhaps the salacious Mr. Weiner will follow suit?

In Mr. Weiner’s defense, by sitting in Congress, he was doing nothing more than following a well worn path of crime, sex scandals and plain old corruption. It is a practice that dates back more than two hundred years.

The Crédit Mobilier scandal of the 1860s touched many in Congress, as cash and stock was passed around the floor of Congress like donuts at morning coffee. Among those admitting accepting stock from Crédit Mobilier was Ohio Republican Congressman James Garfield. Not only did Mr. Garfield avoid censure, he got elected President in 1880. (Of course he was assassinated four months later.) The Watergate episode in 1973 reminded the country of one of Washington’s funniest lines, “I am not a crook.” The speaker, the late Richard Nixon, became the first President to resign from office.

Above all highways leading to the nation’s capital, there must be signs declaring: “Abandon Morality, All Ye Who Enter.” Washington serves as a School for Scandal for aspiring writers for the New York Post. There is so much material. Who can forget Senator Kennedy’s episode on (and off) the bridge at Chappaquiddick? Or Adam Clayton Powell dipping into congressional funds for personal travel? Or Newt Gingrich and his $4.5 million book contract? Or this past year, Charlie Rangel’s soliciting donations for personal consumption? The common thread among these paragons of virtue is that they were all reelected.

Not all sexual scandals involve heterosexuals. Republican Representative Mark Foley of Florida sent compromising e-mails to teenage congressional pages. Foley resigned. Republican Senator Larry Craig of Idaho had a bizarre encounter in an airport bathroom. Craig did not seek reelection.

Democrats, as Yahoo! News put it, “have not been immune to being caught inflagrante delicto.” Representative Mel Reynolds of Illinois was caught with a sixteen-year old campaign worker. His efforts landed him in jail. Barney Frank, incredibly, was keeping company with a male prostitute named Steve Gobie. The enterprising Mr. Gobie was using their mutual apartment as a brothel. The ever-discerning folks in Massachusetts have continued to reelect the ethically challenged Mr. Frank. They would be better off listening to P.J. O’Rourke who once said, “Don’t vote; it only encourages the bastards.”

Not to be left behind, Californian Republican Congresswoman, Mary Bono Mack was seen in a photograph with another woman “playfully” licking her breast. Ms. Mack (widow of Sonny Bono) is described as a “family values lawyer.” Of course, if she wants her breasts licked, who are the people to say she shouldn’t.

So Anthony Weiner finds himself amid an expanding swarm of smarmy politicians. He will not garner a footnote when the history of this period is written. Nevertheless, he represents a prototypical example of the excesses of our age – an era that dwells on self, with an arrogant, belittling attitude. The concept of service has evaporated. A sense of entitlement has arrived. The people of New York’s 9th District deserve better. Isn’t it time to consider term limits?

Tuesday, June 7, 2011

Excess leverage was the root cause for the financial crisis of three years ago. Deleveraging is the only response. Had government not intervened in the fall of 2008, the global financial system might well have collapsed. We will never know the truth of that statement, but no thinking person would want to reenact those days to find out for sure. Stories this morning suggest that the Federal Reserve will back a 3% surcharge on banks, taking Tier 1 capital ratio requirements for some large banks to 10%. Placing a governor on banks is necessary, after the risk they placed the country in, but the consequences will be higher interest rates and slower economic growth.

In terms of massive future financial obligations, the private sector is far ahead of the public sector. Three decades ago, companies could see the end game in defined benefit plans, so began converting to defined contribution plans. In terms of operations, nonfinancial corporations began deleveraging a few years ago, so entered the recession in reasonably good shape. However, for the rest of the economy it was akin to driving a Deux Chevaux on a German autobahn – one small move and you were dead. Between 2000 and 2008, mortgage debt in the U.S. increased by 112%, from $6.9 trillion to $14.6 trillion. Credit card debt increased 73%. Yet GDP rose only 40%, a visible manifestation of debt driven economic growth. Many banks spent the decade making increasingly dicier bets, in some cases increasing their leverage so that, including off balance sheet obligations, capital ratios fell to two percent or below. Leverage utilized by government sponsored entities such as Fannie Mae and Freddie Mac approached 100-1. The small boy was right, the emperor was naked.

The credit crisis slammed the brakes on consumer borrowing, accentuating a recession already underway. As banks, corporations and consumers deleveraged, the debt water table remained essentially the same; the shift descended onto the shoulders of the federal government. The decision by government to step into the breach was noble and correct in the fall of 2008. We can argue about the tools employed, but it is hard to argue as to the necessity for intervention at the time. But it is also important to recognize that deleveraging is necessary and, by definition, means less economic growth and higher unemployment. You can put molasses on a turnip, but it is still a turnip.

Government stimulus spending of more than $800 billion in 2009 did little to alleviate the situation, other than to postpone a day of reckoning for the States. That day of reckoning has arrived. Indicative of the financial plight we now face, the Wall Street Journal notes this morning that Jefferson County, Alabama is being forced to consider laying off a third of their employees. We are facing a labor market that seems incapable of expanding fast enough to absorb the roughly 100,000 new entrants each month, not to mention alleviating the estimated seventeen million under and unemployed. Because of the level of federal debt, we no longer have the options we had in earlier crises. In 2000, U.S. federal debt was roughly 35% of GDP; today it is over 90%. This ratio is the highest since World War II when 16,000,000 Americans served in the Armed Forces, the equivalent of 40,000,000 today. The comment from screenwriter Billy Wilder comes to mind: The situation is hopeless, but not serious.”

Small business is the engine of economic growth. The government could do more in terms of raising confidence and providing tax incentives for these enterprises. The bulk of small business’ capital needs are satisfied via bank lending. And therein lies the rub. Speaking at the Peterson Institute for International Economics last Friday, Federal Reserve Governor Daniel Tarullo suggested that the Federal Reserve may consider tightening reserve requirements for U.S. banks with assets in excess of $50 billion beyond those required under Basel III. “A post-crisis regulatory regime,” he said, “must include a significant macroprudential component.” That component, utilizing sliding scales, would raise capital requirements based on size of the bank and the degree of risk correlation of its assets. Higher capital requirements, of course, mean fewer funds available for lending. Shrinking supply generally foretells higher prices. But it is the price we must pay.

In the meantime, the American banking industry has been consolidating. At the end of 2007, there were 8,542 banks. At the end of 2010, there were 7,666, suggesting 876 banks either failed or had been merged during the past three years. In 2009, thirty-four banks had assets in excess of $50 billion and 117 had assets in excess of $10 billion, indicating that most banks are small and so of little risk of creating systemic failure. And big banks continue to get bigger. A consequence of the financial crisis (intended or not) has been that big banks have become bigger. As of December 31 2007, banks with more than $50 billion accounted for 64.5% of banking assets; by the end of 2010 those banks held 68% of such assets. It is banks like Citigroup, Bank of America, JP Morgan and Wells Fargo – banks with assets in excess of $1 trillion – at which the more stringent reserve requirements are aimed. Adhering to the new rules is considered imperative to preserving the system, but the consequence will be higher interest rates and slower economic growth.

This view may seem unduly pessimistic. After all, consumer and bank deleveraging have been underway for two and a half years. And one should never underestimate the creativity and entrepreneurial spirit of Americans. As I have written before, just because the path ahead may not be visible does not meant it is not there. But we need the federal government to get on board: acknowledging its enormous debt and proscribing a way to reduce it, instilling confidence and easing the way for small businesses to continue to grow and to hire. Unless the administration chooses to inflate its way out, deleveraging will persist, suggesting at best only modest growth. In this time of fiscal and economic fragility, the nomination of former utility executive and environmental advocate John Bryson as Commerce Secretary sends exactly the wrong message.

Monday, June 6, 2011

Free markets are important to the success of capitalism. In financial markets, competition plays an integral role. Markets function best when sunlight is allowed. Collusion, whether between businesses to fix pricing, or symbiotic dealings between business and politicians to find means of bypassing regulation in exchange for political gifts, damages capitalism. Rules and commonsense matter; transparency in markets is what provides confidence. And confidence is the single most critical element in the smooth functioning of capital markets.

Wall Street is unique, in that millions of dollars can be traded with no papers to be signed and no lawyer present. We take this for granted. Yet it is remarkable, and it is unlike any other major transaction one makes. Can you imagine buying real estate without a covey of lawyers? Even the purchase of a car consumes reams of paper work. We do so with securities because of the faith investors have in the integrity of largely self-regulated exchanges, with rigorous listing requirements and in the governmental agencies that oversee them. It is a system that dates back to twenty-four brokers trading under a Buttonwood tree outside of 68 Wall Street in 1792, and a system that was strengthened with the creation of the SEC in 1933.

But all that is changing. Listing requirements and self-regulation are no longer as relevant. For every share of a New York Stock Exchange listed stock that trades on the Exchange between three and four shares trade “off board.” They may be dual-listed shares, or they may trade on an electronic exchange. Exchanges, according to Jayanth Varma, a professor of finance at the Indian Institute of Finance in Ahmedabad, India, have become the equivalent of shopping malls for securities. Surveillance by individual markets has become an anachronism. A stock exchange that only sees trades on its market, as Professor Varma writes, “is no match for a market manipulator who trades in multiple cash and derivative exchanges (as well as the OTC markets) and shifts positions across markets to avoid detection.” The flash crash of May 6, 2010 is exhibit A.

The last three decades have seen a proliferation of global markets and a relative decline of the importance of New York. In 1995, the United States had 8000 listed public companies. Today that number is 5000. During those same fifteen years, listings on non-U.S. exchanges expanded from 23,000 to 40,000. In February, the Wall Street Journal, in discussing the announced deal by the Deutsche Börse to purchase the NYSE, wrote that the 171 IPOs in the United States last year were dwarfed by 1,295 overseas .

Blame for the decline in listings since 2002 has generally been laid on Sarbanes-Oxley, which was designed to reduce the opacity of financial reporting and to place the direct responsibility for reported numbers on the backs of senior corporate managements. There is little question that the cost for compliance was far greater on smaller companies than large ones; thus “going public” in traditional ways has become a less attractive alternative for smaller businesses. The Dodd-Frank Bill exempted companies with less than $75 million in public securities from what has become to be known as Sox 404(b). Nevertheless, the passage of Sarbanes-Oxley, in my opinion, has proven to be a situation in which good intentions result in damaging, unintended consequences. Nick Schulz reviews a new book by Henry Nothhaft, in this morning’s Wall Street Journal. In the review, Mr. Schulz writes that, while government estimated that compliance with Sarbanes-Oxley would be $91,000. However, a mobile-internet firm, Danger, Mr. Nothhaft was preparing to go public in 2007 had to spend $3 million to become compliant.

While the U.S. has lost listings to overseas markets, our share of global GDP has remained the same (25%) since 1995, according to an interview in this weekend’s edition of the Wall Street Journal, suggesting a decline in the ratio of the number of public companies to GDP.

Senator Charles Schumer has favored Germany’s Deutsch Börse’s takeover of the NYSE; he says he was motivated solely by his desire of “keeping New York the number one financial center of the world.” Schumer’s comments were in response to Chicago’s rise in the competing derivative’s market. Roger Altman, of Evercore Partners, pointed out, accurately in my opinion, that “the greatest threat to New York is not Chicago. It’s Hong Kong and China by a mile.”

But it is confidence in markets that should be the final arbiter. Regulators and the American investing public are faced with a dilemma: Is it more important to compete more aggressively so that New York can maintain its position as the center of global capitalism, or should a framework be provided (or maintained) that makes listing requirements more difficult, but would ensure standards that diminish the likelihood of fraud or manipulation?

The latter, in my opinion, is the best route. Confidence in markets is the “forest” and global competition is the “trees.” An article in last Thursday’s New York Post was brought to my attention and served to highlight this quandary. The headline read: “Nasdaq aims for direct stock sales.” NASDAQ unveiled a plan in which they would link up with an internet startup, Loyal3 to sell stock directly to consumers via the web, including through social networking site Facebook.

The recommendation is tempting. A consumer purchases a product and deems it of exceptional value; so chooses to invest in the business. Why not treat the request similarly to buying a book on Amazon after reading a flattering review in the Sunday New York Times? My short answer is because dollars for investment are different. When we buy a book, we get a physical copy, unless it is an e-book, in which case it is downloaded in seconds to our Kindle. When one invests in a security, one is looking for a future stream of income that will be used either to pay dividends or interest, or will be used to enhance the value of the enterprise. Billions of dollars are traded daily on exchanges. It is too easy for frauds and thieves to take advantage of the vulnerable and naive. Dollars for investment are not trivial. They have specific purposes, the most important of which are providing for one’s security and retirement.

There seems little doubt that too-high tax rates and excessive regulation have inhibited the growth and development of small businesses, which do most of the hiring. And we all also hope New York maintains its position as the financial capital of the world, but not at the cost of sacrificing confidence in the integrity of markets. Investors can already buy stocks electronically at any hour of the day. But, to let unscrutinized companies issue stock via a Facebook account makes about as much sense as a Congressman exposing himself on Twitter.

Thursday, June 2, 2011

Complex problems require simply stated solutions. They also require adult conversations. The Republican Party, in its attempt to defend the Ryan plan for Medicare reform, failed the first test. The Democratic Party has failed the second.

When President Obama presented his fiscal 2012 budget (a budget that was rejected in the Senate 97-0,) he called for an “adult conversation on the nation’s finances.” Then he went out and played golf. (Or, maybe I am confusing that day with Memorial Day!) On April 13, when he was expected to deliver his plan to “pay down our debt” during a speech at George Washington University, he spent the first half bashing Representative Paul Ryan’s plan for Medicare and the second half speaking in terms of twelve year plans, a concept which makes the five year plans of the former Soviet Union look reasonable. What is needed, as former Canadian Finance Minister Paul Martin demonstrated in the early 1990s, is a plan for this year and next, recognizing that the future is nothing more than a collection of tomorrows. The President is a master of portraying a world we would all like – yellow brick road and all. He is incapable of embracing a world we can afford.

Representative Paul Ryan took a bold stand when he outlined a plan to save Medicare. He knew he would be slammed and ridiculed, but the President had called for adult conversations; so he took a shot. The President professes to be a man who is interested in ideas and the dialectics of logical discussions as a means of incorporating differing views. He has proven, though, to be a far better practitioner of Chicago gutter politics – pillorying those who dare to disagree, while offering nothing in return.

Republicans failed their constituents when they proved incapable of defending a plan that is designed to save, not destroy Medicare. The commonsense-challenged former House Speaker, Newt Gingrich referred to the plan as “right-wing social engineering.” Their loss of New York’s 26th District was portrayed as a referendum on the Ryan Plan, so when a Democrat won this historically Republican district it was determined that the voters had said “no” to Medicare reform. The Senate defeated the Ryan Plan on May 25th 57-40, with five Republicans voting against it. (Kentucky Senator Rand Paul voted no on the Plan, because it does not reduce costs enough.) Massachusetts Republican Scott Brown said he would not back the Plan. House Ways and Means Chairman, Dave Camp of Michigan, said: “People in my district like Medicare.”

Mr. Camp stated the obvious. Medicare is popular. That is indisputable. The problem is that it will be insolvent in less than ten years. As a child, I used to like my birthday for the gifts I received. I wanted a birthday every week, but was told that wasn’t going to happen. Mr. Ryan wants to save Medicare for future generations. Left alone, it will go bankrupt. Thomas Dolan, writing in Barron’s put it bluntly: “The public wants what it wants, when it wants it and it doesn’t want to pay for it.” Mr. Ryan’s Plan may not be the best plan, but it should have been a starting point for adult conversations. Ignoring a problem, any more than knocking possible solutions, will not make that problem disappear. The role of leaders is to help people recognize the world as it is, not as they would prefer it.

With the exception of former President Clinton, the response of Democrats has been non-serious. Michael Barone reported last week in Investors Business Daily that 1,372 organizations, covering 3,095,593 individuals, have been granted waivers from Obamacare. Union members make up 12% of the workforce, but they constitute 50.3% of workers now exempted from Obamacare. Thirty-eight waivers were granted to businesses in Nancy Pelosi’s Congressional District in San Francisco. So much for “we’ll find out what’s in it once we pass it.” In place of proposing alternatives, their idea is to let Mr. Ryan dangle in the wind, the bulk of which emanates from their own lungs. Proudly, they showed Mr. Ryan “throwing grandma off a cliff.” “Mediscare” has become the Democrats’ new buzz word. And of course, Democrats said nothing about Obamacare’s ripping $500 billion from Medicare, so the President’s new healthcare entitlement would be financially viable, at least according to their accounting.

On Tuesday, Republicans put forward a bill to increase the debt ceiling with no concurrent plans to rein in deficits. The Democrats called it a sham – the staging of a bill Republicans didn’t want passed. Of course. That’s exactly what it was, but it proved the point. Of 192 House Democrats, only 82 voted for the measure. Even spendthrift Democrats have to recognize that so much wool has been pulled over the eyes of their constituents that the sheep are bleating. The debt ceiling will surely be increased, probably in July or early August, but astounding to me is that Treasury wants to increase the level by 17%. It’s debt, not the debt ceiling, that’s the problem Last year federal spending constituted 25% of GDP. How big do they want government to be? Whatever happened to fiscal prudence?

To understand the future we face if we don’t seriously address the problems of entitlements, one has to look no further than Europe and specifically to the PIIGS nations. The European Central Bank has backed a plan that would “encourage” banks to rollover maturing Greek debt, offer higher coupons and/or increased collateral. This morning’s recommendation by Jean-Claude Trichet for a new Euro Finance Ministry, with powers to affect tax policy in individual countries, seems more a pipe dream than a real possibility. An unidentified senior official in the Greek Finance Ministry, according to a news report in yesterday’s New York Times, said it meant: “Restructuring is off the table. For now it is all about growth, growth, growth.” Growth? From where? A condition of the loan extension is an emphasis on austerity. It reminds me of my mother-in-law speaking of hard times when meals consisted of wind pudding and air sauce. As much as they want to delay the inevitable, restructuring will happen. If they are lucky, time might ease the burden. If they are unlucky, it will worsen. In the meantime, wealthy Greeks have been voting with their feet. According to the same article in the Times, since the crisis began €60 billion in deposits have been withdrawn from Greek banks – almost 20% of their GDP! Equivalent withdrawals from U.S. banks would amount to just under $3 trillion.

For years, no American politician has dared touch entitlements. It was far more pleasant to kick the pail down the road. President Bush, coming off re-election in 2005, made an attempt to reform Social Security. He was ambushed by his own party. Attempts are being made again, but this time Democrats are playing ostrich, hoping the problem will go away, at least until 2013. However, each year we delay facing the debts we have incurred means an increase in the negative consequences. Whether the pail is too dented or the road has come to an end, I don’t know, but the option of doing nothing is no longer an option.

Dutch legend has it that there once was a small boy who, on his way to school, passed a dyke with a slight leak letting sea water trickle slowly through a little hole. Being more responsible than members of our representatives in Washington, or members of the European Union, he plugged the hole with his finger, knowing he would be in trouble for being late to school. But he also knew that trickles of water, unstopped, become torrents.

Our situation, unfortunately, is worse. The trickle has become a stream. While no politician will admit it, we can no longer afford the entitlements government has been granting and that the people have come to expect as their right. Our debt is destroying us. Our infrastructure is crumbling. Our military is spread too thin. Our space program is being dismantled. Our schools are uncompetitive. The country has to refocus on creating wealth for the middle class and less time distributing it. That may sound harsh, but it is the only way out of the morass.

Wednesday, June 1, 2011

We all know that companies are born, mature and eventually die – some early while others last for centuries. Today, when one looks at a few darlings from a decade ago, one can easily conclude that the highway to the graveyard for elephants has become crowded. Ten household names – Microsoft, Intel, Pfizer, Merck, JP Morgan, Cisco, Home Depot, GE, Citigroup and United Airlines – have, in aggregate, lost more than 40% of their value over the past ten years. All of them are lower than they were then. Granted, it was a difficult decade for stocks. The S&P 500 gained a mere 6%, and the NASDAQ remains more than 46% below its all-time peak in March 2000.

To be clear, we do not provide any fundamental research on the ten companies mentioned above. My comments are merely empirical observations. My interest is more in the exogenous reasons for their price declines and what the price of the stocks may be saying about the behavior of investors today.

The last ten years included two enormous shocks. The first was the collapse of the tech-internet bubble that peaked in March 2000. By the time the bottom finally appeared in October 2002 an estimated $6 trillion of equity value had been lost. Then, six years later, the credit collapse in 2007-2008 precipitated a 58% decline in the S&P 500. Despite the end of the tech bubble, the attack on 9/11 and the near collapse of the financial markets, over the decade GDP rose 46% and household net worth increased 38%. Neither number has been inflation adjusted, so the real gains were pretty anemic. (Inflation, as measured by the CPI, reduced the value of the Dollar by about 27% during the past decade.)

Ten years ago tech stocks were expensive and Microsoft, Cisco and Intel were no exception. The most extreme case, Cisco at its peak of $82 sold at 170 times earnings. Over the past ten years earnings compounded at 14% and the stock now sells at just over ten times the $1.60 consensus estimate for 2011. Less dramatically, the same was true for the other companies. Jack Welch was CEO of General Electric for twenty years, resigning in 2001. During his tenure this conglomerate of industrial equipment, household products and financial services reported remarkably smoothed earnings. Once he resigned, the multiple began to contract as the blind faith in Mr. Welch’s accomplishments was replaced with agnosticism. But it wasn’t until the credit crisis hit that the risk embedded in GE Capital surfaced. Current CEO Jeff Immelt has spent the last few years in damage control. But the essence of their business is still the same; revenues over the decade have risen from roughly $100 billion to $150 billion and the stock now sells at fifteen times the 2011 consensus estimate, less than half the multiple the stock sold for ten years ago.

The high cost of developing new drugs, a more restrictive FDA and the unknown consequences of Obamacare have weighed on drug companies. Both Pfizer and Merck are half the price they were ten years ago. Both are now selling for less than ten times earnings and each provides a dividend yield of about four percent.

Warren Buffet famously pointed out a few years ago that airlines, in all the years they had been public, collectively had lost money. However, at dinner Sunday night with Steve Kroll from our office and two well-known, influential large cap buyers, it was pointed out that in four of the last five years airlines such as United had generated sizable amounts of free cash flow – and that, despite very high oil prices. According to Yahoo Finance, today United Airlines’ operating cash flow provides a 30% yield.

All of these companies are international, so one should expect that they will benefit from continued economic growth overseas. In particular, the two banks on the list should benefit from returns to stability domestically and from growth in emerging markets. Additionally, the opportunity for income exists as dividends are restored (Citigroup) or increased (JP Morgan.)

When stocks are cheap, the main reason is fear. When they are dear, greed dominates. It’s hard to argue that there is much fear in the market today, though skepticism is certainly prevalent. But, similarly, greed is not visibly present. There are exceptions, though. Currently trading at $81.58, Linkedin is selling at 26.3X trailing twelve month revenues. However, the unique opportunities that existed in the aftermath of the credit collapse, especially in High Yield Bonds and small cap stocks, are no longer there. It is large cap stocks, such as the ones mentioned, that appear to be the wall flowers of the current era.

Apart from valuation, the avoidance of large cap stocks reflects larger trends. Forty years ago, the market was dominated by individuals who bought “good” companies and happily held them, collecting dividends. Over the past three or four decades, mutual funds largely replaced individuals; today professional money managers are the dominant factors in the investment process. On balance, they tend to be faster to respond to improving fundamentals or deteriorating financials. The better ones have no trouble holding management’s feet to the fire when conditions dictate. On the other hand, some professional managers encouraged the use of options, determining it would align management’s interests with shareholders. The unintended consequence, though, was that such options enriched managements at the expense of shareholders. Additionally, too many money managers fall victim to the malady of momentum, soaring this way and that like flocks of Starlings.

Both large cap managers with whom Steve and I had dinner on Sunday are investors, not traders. They agreed that dividends are more important than stock buybacks and that the most significant risk to markets is uncontrolled spending in Washington. In retrospect, market moves are logical responses to conditions. The trick is understanding where we are today. I don’t pretend to know. In his recent letter to investors, Howard Marks of Oaktree Capital wrote, “There’s nothing more risky than a widespread belief that there’s no risk.” That attitude, in my opinion, permeates Congress and the White House. There is a crisis brewing over the nation’s debt; yet the Administration and many Democrats seem more concerned with increasing borrowing limits than with addressing the cause of the debt.

But every environment provides opportunity. Knowledge of the past can be helpful in what it can tell us about human behavior. Investors are often like lemmings, following one another off a cliff. The corollary to Mr. Mark’s observation is that nothing provides opportunity like potential ignored. With the above ten stocks selling at an average multiple of 10.3X forward earnings and with an average yield of 2.3%, there appears to be limited risk and upside potential in many large cap stocks. Keep in mind, these comments are mine and are not based on our firm’s research.